IBM 2004 Annual Report Download - page 55

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
53
International Business Machines Corporation and Subsidiary Companies
ibm annual report 2004
income taxes
Income tax expense is based on reported income before income taxes. Deferred income
taxes reflect the effect of temporary differences between asset and liability amounts that
are recognized for financial reporting purposes and the amounts that are recognized for
income tax purposes. These deferred taxes are measured by applying currently enacted
tax laws. Valuation allowances are recognized to reduce deferred tax assets to the amount
that will more likely than not be realized. In assessing the likelihood of realization, manage-
ment considers estimates of future taxable income.
translation of non-u.s. currency amounts
Assets and liabilities of non-U.S. subsidiaries that operate in a local currency environment
are translated to U.S. dollars at year-end exchange rates. Income and expense items are
translated at weighted-average rates of exchange prevailing during the year. Translation
adjustments are recorded in Accumulated gains and (losses) not affecting retained earn-
ings within Stockholders’ equity.
Inventories, Plant, rental machines and other property-net, and other non-monetary
assets and liabilities of non-U.S. subsidiaries and branches that operate in U.S. dollars, or
whose economic environment is highly inflationary, are translated at approximate exchange
rates prevailing when the company acquired the assets or liabilities. All other assets and
liabilities are translated at year-end exchange rates. Cost of sales and depreciation are
translated at historical exchange rates. All other income and expense items are translated
at the weighted-average rates of exchange prevailing during the year. Gains and losses
that result from translation are included in net income.
derivatives
All derivatives are recognized in the Consolidated Statement of Financial Position at fair
value and are reported in Prepaid expenses and other current assets, Investments and
sundry assets, Other accrued expenses and liabilities or Other liabilities. Classification of each
derivative as current or non-current is based upon whether the maturity of the instrument
is less than or greater than 12 months. To qualify for hedge accounting in accordance with
SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities,” as amended
by SFAS No. 138, “Accounting for Certain Derivative Instruments and Certain Hedging
Activities,” and SFAS No. 149, “Amendment of Statement 133 on Derivative Instruments
and Hedging Activities,” (SFAS No. 133), the company requires that the instruments be
effective in reducing the risk exposure that they are designated to hedge. For instruments
that hedge cash flows, hedge effectiveness criteria also require that it be probable that the
underlying transaction will occur. Instruments that meet established accounting criteria are
formally designated as hedges at the inception of the contract. These criteria demonstrate
that the derivative is expected to be highly effective at offsetting changes in fair value or
cash flows of the underlying exposure both at inception of the hedging relationship
and on an ongoing basis. The assessment of hedge effectiveness and ineffectiveness is
formally documented at hedge inception and reviewed at least quarterly throughout the
designated hedge period.
The company applies hedge accounting in accordance with SFAS No. 133, whereby
the company designates each derivative as a hedge of: (1) the fair value of a recognized
asset or liability or of an unrecognized firm commitment (“fair value” hedge); (2) the vari-
ability of anticipated cash flows of a forecasted transaction or the cash flows to be received
or paid related to a recognized asset or liability (“cash flow” hedge); or (3) a hedge of a
long-term investment (“net investment” hedge) in a foreign operation. From time to time,
however, the company may enter into derivative arrangements that economically hedge
certain of its risks, even though hedge accounting does not apply under SFAS No. 133 or
the company elects not to apply hedge accounting under SFAS No. 133. In these cases,
there generally exists a natural hedging relationship in which changes in the fair value of
the derivative, which are recognized currently in net income, act as an economic offset to
changes in the fair value of the underlying hedged item(s).
Changes in the fair value of a derivative that is designated as a fair value hedge, along
with offsetting changes in the fair value of the underlying hedged exposure, are recorded
in earnings each period. For hedges of interest rate risk, the fair value adjustments are
recorded as adjustments to Interest expense and Cost of Global Financing in the Consoli-
dated Statement of Earnings. For hedges of currency risk associated with recorded assets
or liabilities, derivative fair value adjustments generally are recognized in Other (income)
and expense in the Consolidated Statement of Earnings. Changes in the fair value of a
derivative that is designated as a cash flow hedge are recorded, net of applicable taxes, in
the Accumulated gains and (losses) not affecting retained earnings, a component of
Stockholders’ equity. When net income is affected by the variability of the underlying cash
flow, the applicable offsetting amount of the gain or loss from the derivative that is deferred
in Stockholders’ equity is released to net income and reported in Interest expense, Cost,
SG&A expense or Other (income) and expense in the Consolidated Statement of Earnings
based on the nature of the underlying cash flow hedged. Effectiveness for net investment
hedging derivatives is measured on a spot-to-spot basis. The effective portions of changes
in the fair value of net investment hedging derivatives and other non-derivative risk
management instruments designated as net investment hedges are recorded as foreign
currency translation adjustments, net of applicable taxes, in the Accumulated gains and
(losses) not affecting retained earnings section of Stockholders’ equity. Changes in the fair
value of the portion of a net investment hedging derivative excluded from the effective-
ness assessment are recorded in Interest expense.
When the underlying hedged item ceases to exist, all changes in the fair value of the
derivative are included in net income each period until the instrument matures. When the
derivative transaction ceases to exist, a hedged asset or liability is no longer adjusted for
changes in its fair value except as required under other relevant accounting standards.
Derivatives that are not designated as hedges, as well as changes in the fair value of deriv-
atives that do not effectively offset changes in the fair value of the underlying hedged item
throughout the designated hedge period (collectively, “ineffectiveness”), are recorded in
net income each period and generally are reported in Other (income) and expense.